TY - JOUR AU - Borenstein,Severin AU - Busse,Meghan AU - Kellogg,Ryan TI - Principal-agent Incentives, Excess Caution, and Market Inefficiency: Evidence From Utility Regulation JF - National Bureau of Economic Research Working Paper Series VL - No. 13679 PY - 2007 Y2 - December 2007 UR - http://www.nber.org/papers/w13679 L1 - http://www.nber.org/papers/w13679.pdf N1 - Author contact info: Severin Borenstein Haas School of Business University of California, Berkeley Berkeley, CA 94720-1900 Tel: 510/642-3689 E-Mail: borenste@haas.berkeley.edu Meghan Busse Northwestern University Kellogg School of Management Management & Strategy, Sixth Floor 2001 Sheridan Road Evanston, IL 60208 Tel: 847/467-3362 Fax: 847/467-1777 E-Mail: m-busse@kellogg.northwestern.edu Ryan Kellogg University of Michigan Department of Economics 238 Lorch Hall 611 Tappan Street Ann Arbor, MI 48109-1220 Tel: 734/764-2371 Fax: 734/764-2769 E-Mail: kelloggr@umich.edu AB - Regulators and firms often use incentive schemes to attract skillful agents and to induce them to put forth effort in pursuit of the principals' goals. Incentive schemes that reward skill and effort, however, may also punish agents for adverse outcomes beyond their control. As a result, such schemes may induce inefficient behavior, as agents try to avoid actions that might make it easier to directly associate a bad outcome with their decisions. In this paper, we study how such caution on the part of individual agents may lead to inefficient market outcomes, focusing on the context of natural gas procurement by regulated public utilities. We posit that a regulated natural gas distribution company may, due to regulatory incentives, engage in excessively cautious behavior by foregoing surplus-increasing gas trades that could be seen ex post as having caused supply curtailments to its customers. We derive testable implications of such behavior and show that the theory is supported empirically in ways that cannot be explained by conventional price risk aversion or other explanations. Furthermore, we demonstrate that the reduction in efficient trade caused by the regulatory mechanism is most severe during periods of relatively high demand and low supply, when the benefits of trade would be greatest. ER -